In the fast-paced world of finance, the practice of high-speed trading has recently come under fire. What is high-frequency trading, and how could it potentially be damaging for the global economy? Here’s everything you need to know to understand this controversy.
1. High-Frequency Trading Is Highly Controversial
High-frequency trading, also known as high-speed trading, is a type of stock trading that relies on algorithms. These fast-paced algorithms allow traders to conduct transactions in mere fractions of a second.
A recent Businessweek article compares these lightning-fast trading transactions to insider trading, noting the following similarities:
“To its most vehement critics, high-frequency trading is not terribly dissimilar [from insider trading]. The most common accusation is that these traders get better information faster than the rest of the market. They do this through three primary methods:
First, they put computer servers next to those of the exchanges, cutting down the time it takes for an order to travel from their computers to the exchanges’ electronic matching engines.
Second, they use faster pathways— fiber-optic cables, microwave towers, and yes, even laser beams— to trade more quickly between far-flung markets such as Chicago and New York.
Last, they pay exchanges for proprietary data feeds. This is where it gets really complicated. These proprietary feeds are different than the public, consolidated data feed maintained by the public exchanges, called the securities information processor, or the SIP. “
2. Author Michael Lewis Blew the Lid Off High-Speed Trading
— W. W. Norton (@wwnorton) April 3, 2014
Michael Lewis is the author of the book “Flash Boys: A Wall Street Revolt,” which you can buy here from Amazon.
This book has vastly increased public awareness of what high-speed trading is, and how it might have damaging effects on the economy. In his book, Lewis argues that high-speed trading is unfair to “the little guy,” meaning average traders and investors.
TIME‘s Austin Gerig analyses the arguments that Lewis made in his book, writing:
“Lewis thinks high-frequency trading (as high-speed trading is often called) is bad — I mean really, really bad — and that high-frequency trading firms, in collusion with market exchanges, have rigged the market against you. Strong claims, no doubt. But is he right?…
Current financial markets are really complex, perhaps overly complex. When you have myriad order types that not everyone understands, two different ways of obtaining market data and pricing orders, and outdated regulation, there certainly can be room for questionable activity, such as quote stuffing or regulatory arbitrage…the idea that high-speed trading can only work to the detriment of the little guy — clearly the little guy, so far, has seen some significant benefits.”
Lewis isn’t the first author to write about the darker side of high-speed trading. In 2013, author Warren Ellis released a novel called “Gun Machine” which dealt with the dangerous lengths traders would go to in order to conduct their trades at the speed of light.
3. Attorney General Eric Holder Investigating High-Speed Trading
Attorney General Eric Holder, pictured above, has confirmed that there is a federal investigation into the practice of high-speed trading. CBS News reports that the FBI is probing accusations that traders are using high-frequency trading practices to create an unfair advantage.
“In the financial sector, concerns have been raised recently about a practice called ‘high-frequency trading,'” Holder said during testimony before a House Appropriations subcommittee. “The practice, which consists of financial brokers and trading firms using advanced computer algorithms and ultra-high speed data networks to execute trades, has rightly received scrutiny from regulators. I can confirm that we at the United States Department of Justice are investigating this practice to determine whether it violates insider trading laws. The Department is committed to ensuring the integrity of our financial markets, and we are determined to follow this investigation wherever the facts and the law may lead.”
It is not yet clear what punishments, if any, might be brought against high-speed traders as a result of the FBI investigation.
4. Charles Schwab Is Against High-Speed Trading
In 45 seconds, Michael Lewis explains how the stock market is rigged. http://t.co/sruC3KTy0u
— Joseph Weisenthal (@TheStalwart) March 31, 2014
Finance legend Charles Schwab is against high-frequency trading practices, according to CNN. Schwab has called high-speed trading a “growing cancer.”
In a blog post, Schwab wrote:
“High-frequency trading isn’t providing more efficient, liquid markets; it is a technological arms race designed to pick the pockets of legitimate market participants. That flies in the face of our markets’ founding principles. “
5. High-Speed Trading Furor Causes Virtu IPO Postponement
The media firestorm surrounding high-speed trading has affected the IPO plans for one Wall Street firm. According to the New York Times, the high-frequency trading firm Virtu Financial has decided to postpone its initial public offering by “at least a week.”
Virtu Financial describes itself as “a leading electronic trading firm and market maker on numerous exchanges and electronic marketplaces in equities, fixed income, currencies and commodities.”
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